Thursday, November 3, 2016

Pensions Lukewarm on Canadian Infrastructure?

The head of Canada Pension Plan Investment Board is taking a cautious approach to infrastructure investments in Canada as it retools its portfolio to manage the challenging investment environment.

Executives from the country’s largest pension fund spoke to the House of Commons finance committee on Tuesday to explain the fund’s investment strategy, its need for independence and evolving approach to risk. The discussion comes ahead of the planned increase to the Canada Pension Plan contributions that workers and employers will make to fund their retirement years, in order to boost the benefits they will receive. That is set to begin in 2019.

On the topic of infrastructure – a major, multibillion-dollar federal government spending priority – the pension fund said it would need to see investment opportunities that meet its specific criteria in order to participate in the spending boom.

CPPIB, which is set to announce next week that its assets now exceed $300-billion, currently makes equity-driven investments in infrastructure. It buys portions of toll roads, shipping ports and pipelines in may parts of the world and receives a relatively steady flow of fees in return. The fund also needs to write cheques for more than $500-million to make these investments manageable and worthwhile. These are conditions rarely satisfied by the infrastructure assets available in Canada, although the largest infrastructure investment the pension fund owns is in Canada – the Ontario Highway 407 toll road.

“That’s been one of the biggest challenges in Canada, and around the world, is there’s just not been enough of those scale opportunities in size, but also that are prepared for our type of investments,” Mark Machin, CEO of CPPIB, told the committee. He noted that the pension fund likes to by operational assets, rather than investing in constructing new projects from scratch.

When it comes to creating an infrastructure bank, as was proposed in a report to the Minister of Finance by the Advisory Council on Economic Growth two weeks ago, Mr. Machin said that “the devil would be in the details of how everything’s implemented.” The report was penned in part by committee members Mark Wiseman, former CPPIB CEO, and current Caisse de dépôt et placement du Québec CEO Michael Sabia.

When pressed on the stress that changes in government and policies would put on an infrastructure investment years in the future, Mr. Machin said this would be one of the major risks.“Infrastructure investments are, by nature, very long-term investments. And therefore the stability of regulatory regimes [and tax regimes] around those investments is very important,” Mr. Machin said.

Mr. Machin was also asked extensively about the pension fund’s risk exposure in the rest of its investments, and the expectation that returns will be “lower for longer” –a theme outlined by the Bank of Canada in recent months.

“It’s a challenging investment environment globally, given central banks’ activity, whether in Japan or in the U.S., Canada and other countries,” Mr. Machin said. CPPIB is trying to further diversify the investments of the fund around the world, to different sectors and strategies to combat this pressure. The fund still has 20 per cent of its investment portfolio in Canada, even as the country represents less than 3 per cent of the global market index.

CPPIB is planning to increase its investment risk tolerance over the next three years, equivalent to a portfolio containing 85-per-cent global equities. But the fund would take a more conservative approach with the money set to come from the expanded CPP contributions. That portfolio will have a lower risk tolerance because it relies more on investment income to pay pensions years into the future than contributions from employees.

You can read the Advisory Council on Economic Growth report, Unleashing Productivity Through Infrastructure, by clicking here. The executive summary and other related documents are available here.

Canada’s large pensions, which have infrastructure investments around the world from shipping and airports in Britain and Europe to toll roads in Mexico, are expressing interest in joining forces with the federal government’s new infrastructure investment bank.

But they stopped short Wednesday of committing their dollars.

“We look forward to seeing the pipeline of infrastructure investments,” Michel Leduc, senior managing director and head of global affairs at the Canada Pension Plan Investment Board, said a day after the Liberal government pledged $81 billion over the next 10 years to fund public infrastructure including public transit and renewable power projects.

The first $15 billion will become available in the spring budget through the newly established Canadian Infrastructure Bank, designed to attract private sector capital to large national and regional projects with revenue-generating potential.

“An infrastructure bank, executed well, has the potential to be a catalyst of the type of infrastructure investment we have witnessed in Australia, United Kingdom, Chile and United States,” Leduc said.

However, while he said infrastructure investments can provide the pension plan’s beneficiaries with value, particular in a “stubbornly” low-interest environment, not all investments are the same and each must fit with CPPIB’s overall strategy.

“Infrastructure is a very broad concept, perhaps just as broad as any reference to investing in stocks. Some stocks are a good fit with our investment portfolio, some less so,” he said.

Leduc said infrastructure investment has worked in markets in which there is a concerted policy aim to attract productive, long-term capital.

“It doesn’t just happen,” he said.

If it is determined that CPPIB, which invests funds not needed to pay current benefits of the Canada Pension Plan, is interested in partnering with the government, the pension giant would be able to exploit a “home market advantage,” he said.

“We know Canada well… the home market advantage is one we would apply fiercely.”

Federal Finance Minister Bill Morneau told the House of Commons finance committee Wednesday the infrastructure bank is needed to spearhead projects because private institutional investors view the dedicated agency as a means to lower political risk.

PPP Canada, a federal Crown corporation that oversees public-private partnerships on infrastructure projects, doesn’t meet all the needs of the private investors, he said.

Ron Mock, chief executive of the Ontario Teachers’ Pension Plan, said a national infrastructure investment strategy in Canada could be “transformative” in terms of productivity, employments, and return on investment — provided it is guided by a long-term vision of commercial viability and independent governance.

The governance structure will be essential to its success to attracting private capital, he said, suggesting the government appoint a strong, professional, and independent board “to ensure it is run like a business.”

Canadian pension plans “have validated the soundness of this model on the global investment stage,” Mock said.

Since entering the infrastructure arena in 2001, Teachers’ has partnered with governments around the world, and used the plan’s governance and management expertise to add value and improve the productivity of these assets, he said.

“In our experience, countries that develop and implement a long-term vision for infrastructure are some of the most economically progressive and productive countries in the world.”

Mock said an infrastructure institution that combines government and institutional investment capital and risk sharing “will significantly improve the Canadian infrastructure landscape.”

Teachers’ was among the first pension plans to invest in infrastructure assets directly and is one of the world’s largest infrastructure investors, with a portfolio of nearly $16 billion as of the end of last year. The portfolio spans market segments including transportation and logistics, water and waste water, gas distribution, and renewable and conventional energy.

Senior advisors at Toronto law firm Bennett Jones LLP said the government has signaled it would be receptive to unsolicited bids for infrastructure projects, which represents a new opportunity for players experienced in project development.

“We think the energy transmission, water, wastewater, and transportation fields are well-suited to this initiative,” David Dodge, former Governor of the Bank of Canada, wrote in a note to clients with senior business advisor Jane Bird.

Ontario Teachers' Pension Plan expressed support for the federal infrastructure investment plan and put out a press release which you can read here.

Following the federal government’s announcement yesterday of its plans to invest in infrastructure, one of Canada’s largest pension funds is advising the government that the implementation of a governance structure will be essential to its success in attracting private capital.

“We recommend the government appoint a strong, professional and independent board to ensure it is run like a business, as is the case for Canadian pension plans, which have validated the soundness of this model on the global investment stage,” said Ron Mock, president and chief executive officer of the Ontario Teachers’ Pension Plan, in a press release.

In his Fall Economic Statement yesterday, Finance Minister Bill Morneau said the federal government will invest an additional $81 billion in public transit, green and social infrastructure and transportation infrastructure, along with a number of other measures.

Canada’s largest pension funds, including the Ontario Teachers’, were among the first pension plans to invest directly in infrastructure assets, noted Mock.

“We believe that a government-backed Canadian infrastructure institution that partners government and institutional investor capital and risk sharing will significantly improve the Canadian infrastructure landscape,” said Mock. “It will benefit the Canadian government and, ultimately, Canadians.”

Since it began investing in infrastructure in 2001, Ontario Teachers’ has partnered with governments around the world, leveraging the fund’s governance and management expertise. “In our experience, countries that develop and implement a long-term vision for infrastructure are some of the most economically progressive and productive countries in the world,” said Mock.

The Ontario Teachers’ infrastructure portfolio is diversified across the transport/logistics, water and waste water, gas distribution, renewable and conventional energy industry sectors.

The Canada Pension Plan Investment Board also addressed infrastructure investment yesterday before the House of Commons finance committee. Mark Machin, chief executive officer of CPPIB, said the pension fund would need to see investment opportunities that meet its specific criteria in order to participate in the spending boom, according to the Globe and Mail.

CPPIB infrastructure investments include toll roads, shipping ports and pipelines around the world but the conditions are rarely satisfied by the infrastructure assets available in Canada, said Machin, although the pension fund is invested in the Ontario Highway 407 toll road.

“That’s been one of the biggest challenges in Canada, and around the world, is there’s just not been enough of those scale opportunities in size, but also that are prepared for our type of investments,” said Machin before the committee. He noted that the pension fund likes to buy operational assets, rather than investing in constructing new projects from scratch.

Mark Machin is right, pension funds are more likely to buy an equity stake in operational assets rather than investing in constructing new projects from scratch (greenfield projects).

The key difference is CDPQ Infra has an experienced team, people who worked at construction and engineering companies like SNC-Lavalin and other people with great project management and project finance experience, so they can handle "construction risk" that goes along with greenfield projects.

Sure, there are pros and cons to any greenfield infrastructure project. The risks are that the project runs into delays, goes way over budget and that cash flow projections are way off (this is why you need an experienced team to handle a major greenfield project).

But if done properly, the benefits are huge because the Caisse will be in control of a major infrastructure project from A to Z, something which is unheard of in the institutional world.

It’s important to make the distinction between operational infrastructure investments and green field ones (specifically ones utilizing the DBFM model, which is being contemplated here).

Quite rightly, Teachers and CPPIB steer clear of the latter because they are far riskier, require specialized legal expertise, and more recently, the application of Lean construction methods to manage successfully to time and dollar budgets. CPPIB and Teachers lack the necessary expertise to assess such infrastructure investment types, which is certainly not a knock against them.

So at the end of the day, Mock’s and Machin’s commentary as it relates to governance of federal government infrastructure projects is irrelevant. Most of the projects will be non-revenue plays and DBFM (i.e. full life cycle) projects and therefore outside of their permitted investment mandates.

These being P3 projects as well, private equity will be the (P)rivate driver, and I would imagine that their risk/reward profile, for those who know how to size them up, will be attractive.

I asked a friend of mine who is an expert in infrastructure to explain all this to me:

DBFM is a type of Public Private Partnership (P3). The acronym describes the risks transferred to the private sector partner. In this case, Design, Build, Finance, and Maintain.

I think that the concept of establishing an infrastructure bank is to expand horizons and getting more projects done. It is not necessarily just about P3s.

In Europe, the European Investment Bank (EIB) has all sorts of tools that help projects to get financed. These tools do not exist in Canada. In the US, tax exempt muni bonds really go a long way to getting things done.

Anyway, just take a drive around Montreal and Ottawa, fairly obvious that the infrastructure is falling apart.

[Note: Andrew Claerhout, Senior Vice-President of Infrastructure & Natural Resources at Ontario Teachers' Pension Plan, gave me a much more detailed response to Chas's comment below in my update at the end of the comment.]

I can vouch for that, Montreal's roads, bridges, sewer and water pipes are falling apart and infrastructure needs are mounting every year.

Of course, all these infrastructure projects are wreaking havoc on the city's traffic which is why I avoid downtown Montreal as much as possible.

[Note: When urban planners were building highways in the 50s and 60s, they certainly didn't plan for so many cars on the road, which is why the traffic nightmare keeps getting worse each year. And as my friend rightly notes, it's high time that people living in Laval or South Shore pay tolls to come into the city and if they don't want to, let them use public transit.]

Anyways, let's get back to the federal infrastructure bank and the role Canada's large pensions or other large global investors are going to play in funding or investing in these projects.

Former Alberta Investment Management (AIMCo) chief executive Leo de Bever is skeptical the federal government can attract foreign investment in critical Canadian infrastructure projects.

In an interview on BNN, de Bever, who’s now the chairman of energy service company Oak Point Energy, said foreign capital may prove disinterested in investing in many of the projects coveted by the Trudeau government.“I don’t think that’s the first place that they’d be looking for,” he said. “The kind of people I talk to about foreign investment want to invest in our resources because they want security of supply [for] their own economies. I don’t think you’re going to get too many people excited about building roads in Canada.”

De Bever said Canadian attitudes toward paying for public infrastructure are at times diametrically opposed to the cash-flow needs of private equity.

“The prevailing wisdom in Canada is still that roads and sewage and so on should be free, and unfortunately infrastructure costs, so it has to earn a return,” he said. “The question is how do you allocate the cost of that infrastructure and if you’re not willing to charge for it, or not charge enough, then you’re not going to attract very much private capital: It’s that simple.”

Smart man that Leo de Bever, take the time to watch this BNN panel discussion below, it's truly excellent (click here to watch it on BNN's site). As always, if you have anything to add, email me at LKolivakis@gmail.com.

Andrew told me that OTPP, CPPIB, OMERS and the rest of Canada's large pensions are not interested in small DMBF/ PPP projects which are typically social infrastructure like building schools, hospitals or prisons. Why? Because they're small projects and the returns are too low for them. However, he said these are great projects for construction companies and lenders because you have the government as your counterparty so no risk of a default.

Instead, he told me they are interested in investing in "larger, more ambitious" infrastructure projects which are economical and make sense for pensions from a risk/ return perspective. In this way he told me that they are not competing with PPPs who typically focus on smaller projects and are complimenting them because they are focusing on much larger projects.

Here is where our conversation got interesting because we started talking about Australia being the model for privatizing infrastructure to help fund new infrastructure projects. He told me that while Australia took the lead in infrastructure, the Canadian model being proposed here takes it one step further. "In Australia, the government builds infrastructure projects and once they are operational (ie. brownfield), they sell equity stakes to investors and use those proceeds to finance new greenfield projects. In Canada, the government is setting up this infrastructure bank which will provide the bulk of the capital on major infrastructure greenfield projects and asks investors to invest alongside it" (ie. take an equity stake in a big greenfield project).

Andrew told me this is a truly novel idea and if they get the implementation and governance right, setting up a qualified and independent board to oversee this new infrastructure bank, it will be mutually beneficial for all parties involved.

In terms of subsidizing pensions, he said unlike pensions which have a fiduciary duty to maximize returns without taking undue risk, the government has a "financial P&L" and a "social P & L" (profit and loss). The social P & L is investing in infrastructure projects that "benefit society" and the economy over the long run. He went on to share this with me. "No doubt, the government is putting up the bulk of the money in the form of bridge capital for large infrastructure projects and pensions will invest alongside them as long as the risk/ return makes sense. The government is reducing the risk for pensions to invest alongside them and we are providing the expertise to help them run these projects more efficiently. If these projects don't turn out to be economical, the government will borne most of the risk, however, if they turn out to be good projects, the government will participate in all the upside" (allowing it to collect more revenues to invest in new projects).

He made it a point to underscore this new model is much better than the government providing grants to subsidize large infrastructure projects because it gets to participate in the upside if these projects turn out to be very good, providing all parties steady long-term revenue streams.

I thank Andrew Claerhout for reaching out to me and sharing these incredible insights on why pensions are not competing with DBFM/ PPPs and are looking instead to invest alongside the federal government in much larger, more ambitious infrastructure projects where they can help it make them economical and profitable over the long run.

I embedded a recent CNBC interview where Andrew Claerhout discusses why returns on OECD-based infrastructure have become competitive, making Asia a new opportunity.

I wish CNBC, BNN or Bloomberg contacted him to discuss the federal government's new initiative to invest in Canadian infrastructure. He's a very smart and nice guy who knows what he's talking about.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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